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Bank capital - Can subordinated debt call the shots?

The Shadow Financial Regulatory Committee, an influential group of US financial thinkers with a lot of clout in Washington, has spent the past year reconsidering bank capital standards. Their recent proposals call for bankers to raise new funding in the form of subordinated debt as a way to curb bad habits.

Author: James Smalhout Bankers have been living dangerously since the early 1980s' debt crisis. Poor practice and inadequate regulation appear to be behind several episodes of bad debts. Senior managers haven't always had the right incentives. They enjoy most of the upside when risky bets pay off, but government guarantees shield them when gambling for redemption fails. And clumsy capital adequacy rules from the Basel Committee haven't always protected taxpayers from the costs. The Shadow Financial Regulatory Committee in the US reckons that the mandatory issuance of subordinated debt by banks could solve many of these problems.

Mitsuhiro Fukao, who heads the Japanese equivalent of the US Shadow Committee, has dubbed subordinated debt "canary bonds" after the canaries that coal miners used to take down mines to warn them about methane gas.

When the birds stopped chirping and fell off their perches it was time to get out. The US Shadow Committee is pushing the idea that investors in subordinated debt will stay closely focused on the condition of the bank because the money they invest is particularly exposed to risk when compared with equity or other types of debt issued by banks.

The market, like the canaries, would signal that something was wrong when sub debt prices slid and yields hit junk levels.

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